A Theory of Noise Trading in Securities Markets

ABSTRACT

In a recent article, Black [1] introduces a type of trading that he terms noise trading. He asserts that noise trading, which
he defines as trading on noise as if it were information, must be a significant factor in securities markets. However, he
does not provide an explanation of why any investors would rationally want to engage in noise trading. The goal of this paper
is to provide such an explanation for one type of investor, managers of investment funds. As shown here, the incentive for
a manager to engage in noise trading arises because of the positive signal that the level of the manager's trading provides
about his or her ability to collect private information concerning current and potential investments. If the manager's compensation
is directly related to investors' perceptions of his or her ability, the manager will then trade more frequently than is justified
on the basis of his or her private information. In addition to providing this explanation for noise trading, the results of
this analysis may also be useful for further empirical exploration of the relation between investment fund portfolio turnover
and subsequent performance.